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A Taxing Tax Covenant?

It is standard practice for Corporate documentation to include covenants. Covenants can have a multitude of purposes and provide contractual parties with legal assurances that something will, or will not, be done in an agreement. The recent judgment in Dodika Ltd v United Luck Group Holdings Ltd [2020] EWHC 2101 emphasises the importance of careful drafting and compliance in this context.

This case covers the wording and compliance of a tax covenant in a Share Purchase Agreement ('SPA'). The claimants were a number of the sellers, who were seeking payment of a portion of the purchase price over £100,000,000 which was held in a Claims Escrow Account. These were to be released in two equal apportionments - on the 31st December 2018 and the 1st July 2019. The SPA however contained provision that these funds could be retained in the event of a claim.

On the 23rd July 2018 the Slovenian Tax Authority issued an investigation into the transfer pricing practices of a group company defined in the SPA. Information relating to this was communicated to a third party agent of the seller. Notably, the SPA contained a tax covenant where the sellers would reimburse the buyer for any tax liabilities arising before the date of completion. The SPA also contained a clause where the buyer must produce a written notice 'stating in reasonable detail that matter which gave rise to such claim, the nature of such claim and (so far as reasonably practicable) the amount claimed'.

As they were unable to quantify damages, the buyers issued a notice to the sellers on the 24th June 2019 for reasonable costs and expenses and an amount equal to the tax liability that may be imposed on them by the Tax Authorities. On the 8th July 2019, the sellers responded arguing that the buyer's notice contained insufficient detail of the matter to give rise to a notified claim. Whether these funds could be released was therefore contingent on the written notice by the buyers under the Tax Covenant, and whether it was valid under the terms of the SPA. If the notice was not valid then the portion of sums would be payable to the sellers as initially agreed.

The High Court held that the notice of claim did not contain the level of detail required under the SPA, and therefore was invalid. The High Court took the viewpoint that the reason for the notice provision was to ensure commercial certainty, to allow the recipient to know about the claim in which they were subject to. The fact that the buyer could not quantify the claim did not render the notice unenforceable. Instead by notifying the sellers that there was 'an investigation by the Slovene Tax Authority … into the subsidiary's transfer pricing activities the buyer had failed to provide sufficient information of the matters giving rise to the claim including the underlying facts, events and circumstances. The buyer should have, to satisfy the clause, explained why a tax claim may arise out of the investigation (not merely that an investigation has arisen), including any relevant evidence.

The High Court also rejected the buyer's argument that the seller's were aware of the communications and discussions with a Tax Authority, and that the notice should be construed in line with their knowledge. The Court took the approach that the purpose of the notice was to contain specific information. In conjunction with the SPA , a reasonable recipient would not have understood the notice to include all previous discussions as part of the factual basis of the claim.

Somewhat positive for some sellers, Dodika Ltd showcases that a vague and brief notice is unlikely to be looked at favourably in a court. Although this is to be determined on a case by case basis, the purpose of a notice is to provide the seller with sufficient detail to enable them to prepare for a claim (subject to legal privilege and the Civil Procedure Rules) and to mitigate them from being blindsided by litigation proceedings. This is pragmatic and reflects commercial reality. This case highlights the importance of detail and fact, and the buyer should ensure that all relevant provisions of the SPA are specifically referred to in the notice. Those relying on a provision should not rely on previous communications to determine fact.

To summarise the judgement in Dodika Ltd provides some useful guidance on issuing a claims notice, namely:

• Provide as much detail in the notice as possible that a claim has arisen or could potentially arise (and why);
• Include all relevant facts relating to the claim (or investigation); and
• Incorporate all relevant provisions from the SPA. This includes any warranties to be relied upon and any outlined timescales.

For more information contact Pauline Wild in our Corporate department via email. Alternatively send any question through to Forbes Solicitors via our online Contact Form.

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